The 20 second summary
The English Court of Appeal has struck down provisions in a sale and purchase agreement that adjusted the price if the seller breached restrictive covenants. The case highlights the risks of having the same consequences apply to a variety of breaches, regardless of the seriousness of the breach.
The courts will not enforce penalty provisions - even where the parties have similar bargaining power. A provision is likely to be a penalty if – in the event of breach – it requires an amount to be paid (or forfeited) that is out of all proportion to the loss suffered.
Breach of the restrictive covenants resulted in a price adjustment
Cavendish Square Holdings BV and another company v Makdessi  EWCA Civ 1539 concerns the sale of a marketing and communications company. Mr Makdessi – the main seller - entered into a sale and purchase agreement with Cavendish under which:
- Cavendish bought the majority of the shares in the company - at a price set by reference to the future performance of the business and payable in instalments;
- put and call options were put in place over the balance of the shares; and
- the sellers gave various restrictive covenants.
The agreement also provided that if a seller breached a restrictive covenant he would become a “defaulting shareholder” and:
- no further payments would be payable for the shares he had already sold; and
- Cavendish could buy his remaining shares at a price that would exclude any value for goodwill.
The Court held that the price adjustment was a penalty - out of all proportion to the loss that may be suffered and not commercially justified
What is a penalty?
This case suggests that:
- where a contract provides that – in the event of breach – a sum is to be paid which is out of all proportion to the loss attributable to the breach, that provision is likely to be regarded as a penalty - because its function is to deter breach. The same principle applies to provisions that require sums or other rights to be forfeited - or property to be transferred at an undervalue;
- however, if there is a commercial justification for the provision, it may not be treated as a penalty; and
- if what is to be paid (or forfeited or transferred) is a genuine pre-estimate of loss, it should not be a penalty.
However, there are no hard and fast rules and the judgment specifically notes that:
- the various presumptions and guidelines established in previous cases are of limited use – as they are rebuttable and not conclusive; and
- each agreement needs to be examined as a whole in the context in which it was made.
Also, a provision may be structured so that it may fall outside the rule against penalties - for example by providing that compliance is a pre-condition of an entitlement, rather than providing that the consequences of breach are that an entitlement is lost.
Why were the provisions in this case penalties?
The High Court had held that the provisions were not penalties - but the Court of Appeal disagreed. The provisions applying in the event of a breach were held to be penalties because:
- a wide range of possible losses could have flowed from a breach of the restrictive covenants – and the withholding of further payments was totally out of proportion to part of that range of losses. The loss would depend upon the covenant that was breached and the nature and extent of the breach – and some of the breaches and losses may be trivial. There was no proportionate relationship between the breach and the amount withheld; and
- the loss that Cavendish suffered because of the breach of the restrictive covenants was not one that it could recover at general law. The loss was purely a reflective loss – ie a loss in value of its shareholding in the company that reflected a loss that the company had suffered and could recover (and so not recoverable by Cavendish as a matter of public policy). Given that Cavendish’s recoverable losses were zero, an adjustment to the price that could amount to millions of dollars was necessarily extravagant and out of all proportion.
Cavendish’s arguments of commercial justification were also rejected. Pointing to the underlying purpose of the provisions – to adjust the price and effect a quick de-coupling of the seller and the Company – was not enough. The terms upon which the price was adjusted and the decoupling effected had to be commercially justifiable. In this case, the terms would allow Cavendish to withhold millions of dollars for any breach of any of the restrictive covenants – and in circumstances where it could recover nothing under general law. The court found that the main purpose of those terms was to deter breach, rather than to compensate for loss.
Of course, this judgment may not be the end of the matter: if there is an appeal, we will be sure to update you as to the result.